Download Circular Flow - Lindbergh Schools

Circular Flow Diagrams
Economists use the circular flow diagram
to show the high degree of economic
interdependence in our economy.
Money flows in one direction
while goods, services, and the
factors of production flow in the
opposite direction.
Circular Flow Diagrams
This simple
circular flow
model shows
two groups of
decision
makers —
Businesses
households (or
individuals)
and businesses.
(Later
government
will be added).
Resource or Factor Market
The
coordinating
mechanism
which brings
together these
decisions is the
market system.
Product Market
Households
Resource (or factor) markets
• Operate as the points of exchange when
individuals sell their resources (land, labor,
capital, and entrepreneurial ability) to
businesses in exchange for money incomes.
• Businesses will demand these resources
to produce goods and services.
• Prices paid for the use of resources are
determined in this market, and will create
the flow of rent, wages, interest and profit
income to the households.
Land, Labor, Capital and Entrepreneurship
Resource or factor Market
Resource Money Payments
Businesses
Households
Product Market
Product markets
• Operate as the points of exchange
between consumers who use money
incomes to buy these goods and
services produced by businesses.
• Money income itself does not have
value, since money must be used in
exchange for the goods and services
that satisfy our wants.
Land, Labor, Capital and Entrepreneurship
Resource or factor Market
Resource Money Payments
Households
Businesses
Money Payments
Product Market
Goods and Services
Why a circular flow?
Households create the demand for goods
and services, while businesses can fill the
demand with the supply that they produce
with the resources sold.
The interaction of demand for goods and services
with the supply of available products determines
the price for the products.
The flow of consumer expenditures
represent the sales revenues or receipts of
the businesses.
Each group of economic units
both buys and sells.
Resource Market
Individuals or households function as
both providers of resources and as
consumers of finished products.
Resource Market
Product Market
Businesses function as buyers of
resources and sellers of finished
Product Market
products.
Scarcity plays a role in this model because
households will only possess a limited
amounts of resources to supply to businesses,
and hence, their money incomes will be
limited.
This limits their demand for
goods and services.
Because resources are scarce, the
output of finished goods and
services is also necessarily limited.
Limitations to Circular Flow model
√ Intra-household and Intra-business
transactions are ignored
√ Government and the financial
markets are ignored.
√ The model implies constant flow of
output and income; the fact is that
these flows are unstable over time.
Land, Labor, Capital and Entrepreneurship
Resource or factor Market
Resource Money Payments
Households
Businesses
Money Payments
Product Market
Goods and Services